CHAPTER THREE

INVENTORY

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 CHAPTER

3 Inventories
LEARNING OBJECTIVES
After studying this chapter, you should be able to:

1. Discuss how to classify and determine inventory.

2. Explain the accounting for inventories and apply the inventory cost flow
methods.
3. Explain the financial effects of the inventory cost flow assumptions.
4. Explain the lower-of-cost-or-net realizable value basis of accounting for
inventories.
5. Indicate the effects of inventory errors on the financial statements.
6. Discuss the presentation of inventory.
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 Classifying and Determining Inventory

Classifying Inventory

Merchandising Manufacturing
Company Company

One Classification: Three Classifications:

 Inventory  Raw Materials
 Work in Process
Regardless of the classification,  Finished Goods
companies report all inventories
under Current Assets on the
statement of financial position.

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 Determining Inventory Quantities

Physical Inventory taken for two reasons:

Perpetual System
1. Check accuracy of inventory records.
2. Determine amount of inventory lost due to wasted raw
materials, shoplifting, or employee theft.

Periodic System
3. Determine the inventory on hand.
4. Determine the cost of goods sold for the period.

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 Determining Inventory Quantities

TAKING A PHYSICAL INVENTORY

Involves counting, weighing, or measuring each kind of
inventory on hand.
Companies often “take inventory”
 when the business is closed or
business is slow.
 at the end of the accounting period.

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 Determining Inventory Quantities

DETERMINING OWNERSHIP OF GOODS

GOODS IN TRANSIT
 Purchased goods not yet received.

 Sold goods not yet delivered.

Goods in transit should be included in the inventory of

the company that has legal title to the goods. Legal title
is determined by the terms of sale.

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 DETERMINING OWNERSHIP OF GOODS

GOODS IN TRANSIT Illustration 2

Terms of sale

Ownership of the goods

passes to the buyer when the
public carrier accepts the
goods from the seller.

Ownership of the goods

remains with the seller until the
goods reach the buyer.

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 Determining Ownership of Goods

Question
Goods in transit should be included in the inventory of the
buyer when the:
a. public carrier accepts the goods from the seller.
b. goods reach the buyer.
c. terms of sale are FOB destination.
d. terms of sale are FOB shipping point.

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 Determining Ownership of Goods

CONSIGNED GOODS
To hold the goods of other parties and try to sell the goods for
them for a fee, but without taking ownership of the goods.
Many car, boat, and antique dealers sell goods on consignment,
why?

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 > DO IT!
Deng Yaping Company completed its inventory count. It arrived at a total inventory
value of ¥200,000. You have been given the information listed below. Discuss how
this information affects the reported cost of inventory.
1. Deng Yaping included in the inventory goods held on consignment for Falls Co.,
costing ¥15,000.
2. The company did not include in the count purchased goods of ¥10,000, which
were in transit (terms: FOB shipping point).
3. The company did not include in the count inventory that had been sold with a
cost of ¥12,000, which was in transit (terms: FOB shipping point).

Solution
1. Goods of ¥15,000 held on consignment should be deducted from the inventory
count.
2. The goods of ¥10,000 purchased FOB shipping point should be added to the
inventory count.
3. Item 3 was treated correctly. Inventory should be ¥195,000
(¥200,000 - ¥15,000 + ¥10,000).
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 Classifying and Determining Inventory

Inventory is accounted for at cost.

 Cost includes all expenditures necessary
to acquire goods and place them in a condition ready for
sale.
 Unit costs are applied to quantities to compute the total
cost of the inventory and the cost of goods sold using the
following costing methods:
► Specific identification
► First-in, first-out (FIFO)
Cost Flow
► Average-cost Assumptions

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 Inventory Costing

Illustration: Carik TV Company purchases three identical 50-

inch TVs on different dates at costs of £700, £750, and £800.
During the year Carik sold two sets at £1,200 each. These
facts are summarized below.

Illustration 3
Data for inventory costing example

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 Specific Identification

If Carik sold the TVs it purchased on February 3 and May 22,

then its cost of goods sold is £1,500 (£700 + £800), and its
ending inventory is £750.

Illustration 4
Specific identification method

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 Specific Identification

Actual physical flow costing method in which items still in

inventory are specifically costed to arrive at the total cost of
the ending inventory.

 Practice is relatively rare.

 Most companies make

assumptions (cost flow
assumptions) about which units
were sold.

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 Cost Flow Assumptions

There are two assumed cost flow methods:

1. First-in, first-out (FIFO)

2. Average-cost

Cost flow does not need be consistent with the physical

movement of the goods.

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 Cost Flow Assumptions

Data for Lin Electronics’ Astro condensers. Illustration

(Beginning Inventory + Purchases) - Ending Inventory = Cost of Goods Sold

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 Cost Flow Assumptions

FIRST-IN, FIRST-OUT (FIFO)

 Costs of the earliest goods purchased are the first to
be recognized in determining cost of goods sold.

 Often parallels actual physical flow of merchandise.

 Companies obtain the cost of the ending inventory by

taking the unit cost of the most recent purchase and
working backward until all units of inventory have been
costed.

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 FIRST-IN, FIRST-OUT (FIFO)

Illustration Allocation of costs—

FIFO method
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 FIRST-IN, FIRST-OUT (FIFO)

• HELPFUL HINT
Another way of thinking about
the calculation of FIFO ending
inventory is the LISH
assumption—last in still here.
Illustration 6
Allocation of costs—FIFO method

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 Cost Flow Assumptions

AVERAGE-COST
 Allocates cost of goods available for sale on the basis
of weighted-average unit cost incurred.

 Applies weighted-average unit cost to the units on

hand to determine cost of the ending inventory.

Illustration
Formula for weighted-average unit cost

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 AVERAGE-COST

Illustration
Allocation of costs—average-cost method

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 AVERAGE-COST

Illustration 11

Illustration
Allocation of costs—average-cost method

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 > DO IT!
The accounting records of Shumway Ag Implement show the following.
Beginning inventory 4,000 units at £ 3
Purchases 6,000 units at £ 4
Sales 7,000 units at £12
Determine the cost of goods sold and ending inventory during the
period under a periodic inventory system using (a) the FIFO
method( b) LIFO method and (c) the average-cost method.
Solution
Cost of goods available for sale = (4,000 × £3) + (6,000 × £4) = £36,000
Ending inventory = 10,000 − 7,000 = 3,000 units
(a) FIFO: £36,000 − (3,000 × £4) = £24,000
(b) Average cost per unit: [(4,000 × £3) + (6,000 × £4)] ÷ 10,000 = £3.60
Average-cost: £36,000 − (3,000 × £3.60) = £25,200
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 Financial Statement and Tax Effects of
Cost Flow Methods

Either of the two cost flow assumptions

is acceptable for use. For example,
 adidas (DEU) and Lenovo (CHN) use the average-cost
method, whereas
 Syngenta Group (CHE) and Nokia (FIN) use FIFO.

A recent survey of IFRS companies, approximately

► 60% use the average-cost method,
► 40% use FIFO, and
► 23% use both for different parts of their inventory.
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 INCOME STATEMENT EFFECTS

Illustration
25 Comparative effects of cost flow methods
 STATEMENT OF FINANCIAL POSITION
EFFECTS

 A major advantage of the FIFO method is that in a period

of inflation, the costs allocated to ending inventory will
approximate their current cost.

 A major shortcoming of the average-cost method is that

in a period of inflation, the costs allocated to ending
inventory may be understated in terms of current cost.

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 TAX EFFECTS

 Both inventory and net income are higher when companies

use FIFO in a period of inflation.

 Average-cost results in the lower income taxes (because

of lower net income) during times of rising prices.

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 Using Cost Flow Methods Consistently

 Method should be used consistently, enhances

comparability.
 Although consistency is preferred, a company may
change its inventory costing method.

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 Cost Flow Assumptions

Question
In periods of rising prices, average-cost will produce:
a. higher net income than FIFO.
b. the same net income as FIFO.
c. lower net income than FIFO.
d. net income equal to the specific identification method.

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 Lower-of-Cost-or-Net Realizable Value

cost is usually the most appropriate basis for valuation of inventory.

Nevertheless, the inventory may be valued at Lower-of-Cost-or-Net

Realizable Value When the value of inventory is lower than its cost
 companies must “write down” the inventory to its net realizable
value.

Net realizable value: Amount that a company expects to realize

(receive from the sale of inventory).

net realizable value is the estimated selling price in the normal course
of business, less estimated costs to complete and sell.

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 Lower-of-Cost-or-Net Realizable Value

Illustration: Assume that Gao TV has the following lines of

merchandise with costs and market values as indicated.

Illustration
Computation of lower-of-cost-or-net realizable value

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 Illustration; assume that ABC Corporation has unfinished
inventory with a sales value of Br. 1,000, estimated cost of
completion of Br. 300. The net realizable value can be
determined as follows.
Inventory—sales value……………………………… Br. 1,000
Less: Estimated cost of completion and…………… 300
Net realizable value………………………………….. 700
A company estimates net realizable value based on the
most reliable evidence of the inventories’ realizable amounts
(expected selling price, expected costs of completion, and
expected costs to sell).
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 To illustrate, ABC Restaurant computes its inventory at LCNRV.
Food Cost Net Realizable Value Final Inventory Value
Spinach ¥ 80,000 ¥120,000 ¥ 80,000
Carrots 100,000 110,000 100,000
Cut beans 50,000 40,000 40,000
Peas 90,000 72,000 72,000
Mixed vegetables 95,000 92,000 92,000
¥384,000

Final Inventory Value:

Spinach Cost (¥80,000) is selected because it is lower than net realizable value.
Carrots Cost (¥100,000) is selected because it is lower than net realizable value.
Cut beans Net realizable value (¥40,000) is selected because it is lower than cost.
Peas Net realizable value (¥72,000) is selected because it is lower than cost.
Mixed vegetables Net realizable value (¥92,000) is selected because it is lower than cost.

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 LCNRV can be applied for:
1. Each individual items
2. Major groups
3. Total items
LCNRV by:
Cost LCNRV Individual Items Major Groups Total Inventory
Frozen
Spinach ¥ 80,000 ¥120,000 ¥ 80,000
Carrots 100,000 110,000 100,000
Cut beans 50,000 40,000 40,000
Total frozen 230,000 270,000 ¥230,000
Canned
Peas 90,000 72,000 72,000
Mixed vegetables 95,000 92,000 92,000
Total canned 185,000 164,000 164,000
Total ¥415,000 ¥434,000 ¥384,000 ¥394,000 ¥415,000

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Recording Net Realizable Value Instead of Cost
One of two methods may be used to record the income effect of valuing
inventory at net realizable value. One method, referred to as the cost-of-
goods-sold method, debits cost of goods sold for the write-down of the
inventory to net realizable value.
As a result, the company does not report a loss in the income statement
because the cost of goods sold already includes the amount of the loss.
The second method, referred to as the loss method, debits a loss account
for the write-down of the inventory to net realizable value.
Assume that the following data is for XYZ Company.
Cost of goods sold (before adjustment to net realizable value) €108,000
Ending inventory (cost) 82,000
Ending inventory (at net realizable value) 70,000

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 The following illustration shows the net realizable value evaluation for ABC
Company and the effect of net realizable value adjustments on income.

Adjustment of Effect on
Inventory Inventory at Net Amount Required Allowance Account Net Income
Date at Cost Realizable Value in Allowance Balance
Account
Dec. 31, 2017 188,000 176,000 12,000 12,000 inc. Decrease
Dec. 31, 2018 194,000 187,000 7,000 5,000 dec. Increase
Dec. 31, 2019 174,000 174,000 0 7,000 dec. Increase
Dec. 31, 2020 182,000 180,000 2,000 2,000 inc. Decrease

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 Inventory Errors
Learning Objective 5
Indicate the effects of
Common Causes: inventory errors on the
financial statements.

 Failure to count or price inventory correctly.

 Not properly recognizing the transfer of legal title to
goods in transit.
 Errors affect both the income statement and statement of
financial position.

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 Income Statement Effects

Inventory errors affect the computation of cost of goods

sold and net income in two periods. Illustration 12
Formula for cost of goods sold

Illustration
Effects of inventory errors on current year’s income statement
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 Income Statement Effects

Inventory errors affect the computation of cost of goods

sold and net income in two periods.
 An error in ending inventory of the current period will have
a reverse effect on net income of the next accounting
period.
 Over the two years, the total net income is correct
because the errors offset each other.
 Ending inventory depends entirely on the accuracy of
taking and costing the inventory.

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 Income Statement Effects Illustration
Effects of inventory errors on
two years’ income statements

2016 2017
Incorrect Correct Incorrect Correct
Sales € 80,000 € 80,000 € 90,000 € 90,000
Beginning inventory 20,000 20,000 12,000 15,000
Cost of goods purchased 40,000 40,000 68,000 68,000
Cost of goods available 60,000 60,000 80,000 83,000
Ending inventory 12,000 15,000 23,000 23,000
Cost of good sold 48,000 45,000 57,000 60,000
Gross profit 32,000 35,000 33,000 30,000
Operating expenses 10,000 10,000 20,000 20,000
Net income € 22,000 € 25,000 € 13,000 € 10,000

Combined income for (€3,000) €3,000

2-year period is correct. Net income Net income
understated overstated

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 Income Statement Effects

Question
Atlantis Company’s ending inventory is understated
NT$122,000. The effects of this error on the current year’s
cost of goods sold and net income, respectively, are:
a. understated, overstated.
b. overstated, understated.
c. overstated, overstated.
d. understated, understated.

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 Statement of Financial Position Effects

Effect of inventory errors on the statement of financial position

is determined by using the basic accounting equation:
Assets = Liabilities + Equity.
Errors in the ending inventory have the following effects.

Illustration
Effects of ending inventory errors on statement of financial position

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 Statement Presentation

Presentation
Statement of Financial Position - Inventory classified as
current asset.

Income Statement - Cost of goods sold is subtracted from

sales.

There also should be disclosure of the

1) major inventory classifications,

2) basis of accounting (cost or LCNRV), and

3) costing method (specific identification, FIFO, or average-

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cost).
APPENDIX 1A Perpetual Inventory System
Learning Objective 7
Apply the inventory cost
Illustration flow methods to perpetual
Inventoriable units and costs inventory records.

Assuming the Perpetual Inventory System, compute Cost of Goods

Sold and Ending Inventory under FIFO and average-cost.
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 First-In-First-Out (FIFO)

Illustration
Perpetual system—FIFO Cost of Goods
Ending Inventory
Sold

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 Average-Cost

Illustration
Perpetual system— Cost of Goods Ending Inventory
average-cost method
Sold

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APPENDIX 1B Estimating Inventories

Gross Profit Method

Estimates the cost of ending inventory by applying a gross
profit rate to net sales.

Illustration
Gross profit method formulas

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 Gross Profit Method
Illustration: Kishwaukee Company’s records for January show net sales
of $200,000, beginning inventory $40,000, and cost of goods purchased
$120,000. The company expects to earn a 30% gross profit rate.
Compute the estimated cost of the ending inventory at January 31 under
the gross profit method. Illustration
Example of gross profit method

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 Retail Inventory Method

Company applies the cost-to-retail percentage to ending

inventory at retail prices to determine inventory at cost.

Illustration
Retail inventory method formulas
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 Retail Inventory Method

Illustration: Illustration
Application of retail inventory method

Note that it is not necessary to take a physical inventory to estimate

the cost of goods on hand at any given time.

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 Retail Inventory Method with Markups and Markdowns
 Retailers use markup and markdown concepts in developing the proper inventory
valuation at the end of the accounting period.
 To obtain the appropriate inventory figures, companies must give proper treatment
to markups, markup cancellations, markdowns, and markdown cancellations.
There are two approaches to calculate cost ratio
a. A cost ratio can be computed after markups and markup cancellations but before markdowns.
b. A cost ratio after both markups and markdowns (and cancellations).
Consider the following example for Sunshine company.
Cost Retail
Beginning inventory € 500 € 1,000
Purchases (net) 20,000 35,000
Markups 3,000

Markup cancellations 1,000

Markdowns 2,500
Markdown cancellations 2,000
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Sales (net) 25,000
 Cost Retail
Beginning inventory € 500 € 1,000
Purchases (net) 20,000 35,000
Merchandise available for sale 20,500 36,000
Add: Markups €3,000
Less: Markup cancellations 1,000
Net markups 2,000
20,500 38,000
€20,500
(A) Cost-to-retail ratio = = 53.9%
€38,000

Deduct:
Markdowns 2,500
Less: Markdown cancellations (2,000)
Net markdowns 500
€20,500 37,500
€20,500
(B) Cost-to-retail ratio = = 54.7%
€37,500

Deduct: Sales (net) 25,000

Ending inventory, at retail €12,500
Ending inventory at cost= (Ending inventory at retail)*(Cost to
retail ratio)

Approach A: 12,500*0.539= 6,737.5

53 Approach B: 12,500*0.547= 6,837.5
Cont’d…
The retail inventory method becomes more complicated when we
consider such items as freight-in, purchase returns and allowances, and
purchase discounts. In the retail method, we treat such items as follows.
 Freight costs are part of the purchase cost.
 Purchase returns are ordinarily considered as a reduction of the price
at both cost and retail.
 Purchase discounts and allowances usually are considered as a
reduction of the cost of purchases.
 Transfers-in from another department are reported in the same way as
purchases from an outside enterprise.
 Normal shortages (breakage, damage, theft, shrinkage) should reduce
the retail column because these goods are no longer available for sale.
 Abnormal shortages, on the other hand, are deducted from both the
cost and retail columns and reported as a special inventory amount or
as a loss.
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Ex-1:
1. loyd Corporation has the following four items in its ending
inventory.
Net Realizable
Item Cost Value (NRV)
Jokers €2,000 €2,100
Penguins 5,000 4,950
Riddlers 4,400 4,625
Scarecrows 3,200 3,830
Determine (a) the LCNRV for each item, and (b) the amount of write-
down, if any, using (1) an item-by item LCNRV evaluation and (2) a
total-group LCNRV evaluation.

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 Ex-2: Assume that KMK Corp. has a beginning inventory
of €60,000 and purchases of €200,000, both at cost. Sales at
selling price amount to €280,000. The gross profit on
selling price is 30 percent. KMK applies the gross profit
method to estimate ending inventory at cost.
Required: how much is the estimated ending inventory?

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Ex-2: The information related to Luzon Company.
Cost Retail
Beginning inventory $ 58,000 $100,000
Purchases (net) 122,000 200,000
Net markups 20,000
Net markdowns 30,000
Sales 186,000
Instructions
(a) Compute the ending inventory at retail.
(b) Compute a cost-to-retail percentage (round to two
decimals) under the following conditions.
(1) Excluding both markups and markdowns.
(2) Excluding markups but including markdowns.

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 End of chapter-3

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